Option trading reveals doubts about silver's rally

TatyanaShumsky

NEW YORK (MarketWatch) -- Silver may be red hot, but large investors are scooping up insurance in ways that reveal doubts about the record-breaking rally.

Gold's cheaper cousin has been the darling of investors looking to get exposure to precious metals in recent months, as gold's $1,500 price tag deterred price-conscious buyers. The rush of new investors has pushed heavily traded June-delivery silver contracts up 49% this year to a record $46.059 an ounce and savvy investors have taken out insurance in the derivatives market against a severe decline.

Last week saw a sudden spike in put options to sell Blackrock's iShares Silver Trust
SLV, -1.05%
the largest physical-silver exchange traded fund and holder of over 70% of all silver held in eight major ETFs, according to Barclays Capital. By holding those options, investors have the right to sell the ETF at preset prices. The volume stayed high this week.

In one of the biggest purchases, investors guarded against a drop below $25, meaning a decline of 45% or more below current levels. Traders said the purchase could be used to protect about 10 million shares of the silver ETF over the next few months. Or it could be used to make a leveraged bet on a steep fall. A holding of 10 million shares is currently worth more than $450 million.

"It's a downside lottery ticket," said Christopher Jacobson, options strategist for Susquehanna Financial Group. "They think the possibility of a full-on selloff is a little more likely than the market [thinks]."

Large retail investors such as mutual funds or high net-worth individuals tend to invest in silver though physical metal exchange-traded funds, which are easier to trade than physical silver. When those investors are worried, they sometimes pick up derivatives to guard against a decline.

Put options act like insurance against lower prices, with the buyer paying a small amount today for the right, but not the obligation, to sell the asset at a fixed price in the future.

Volume in the silver ETFs put options jumped to a two-day record thanks in part to that big move on April 11 and another the following day to guard against a drop of about 21% from current levels. Then, this week, on Wednesday and Thursday, volume reached another two-day record.

The trading has pushed the number of bearish silver ETF options in the market almost equal with the number of bullish calls to buy the ETF. Trading in those bullish silver options routinely outpaces bearish puts.

"When you see a trade that size you're left scratching your head-- is it smart money or is it dumb money, is this a fund that's hedging positions or is this a large speculator," said Rob Kurzatkowski, senior commodities analyst with optionsXpress.

It is unclear what funds or investors are bracing for lower silver prices. Brokers often jealously guard the information even when, like last week's, the trades turn heads.

But the trades show cautionary sentiment among large market participants. Silver has outperformed gold's gains of 5.6%. Since investment demand for both metals is driven higher by the same set of factors--fears of uncertainty, higher inflation and a distrust of paper currencies, some market watchers say buying insurance seems prudent. Futures haven't yet breached front-month record of $50.360 from January 1980, when the Hunt brothers from Texas tried to corner the market.

"Should gold suddenly turn around and correct, the silver market would get pounded by a much higher percentage rate," said Bill O'Neill, a principal with LOGIC Advisors. O'Neill added that he doesn't recommend silver for his clients because prices are very volatile.

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